We use cookies to customise content for your subscription and for analytics.If you continue to browse Lexology, we will assume that you are happy to receive all our cookies. For further information please read our Cookie Policy.

California court: insurer waived right to rescind policy by not investigating application’s misrepresentation

Why it matters: Despite misrepresentations in a policy application, a California federal court ruled that a recycling company was entitled to almost $1 million in coverage because the insurer waived its right to rescind. Sunwest Metals Inc. purchased two commercial general liability policies for its recycling operations facility from Star Insurance Co. But when arson occurred, Star refused to cover the policyholder’s losses and instead sought to rescind the policies. Star alleged that Sunwest misrepresented the nature of its operations in its application and because it did not truthfully qualify for the “scrap dealer program,” the policy was void. Nevertheless, after a bench trial, a magistrate judge ruled that the evidence established that Star received multiple documents and communications that raised “red flags” and that put it on notice that Sunwest’s business operations were different in scope than represented and Star failed to investigate or undertake any affirmative due diligence to evaluate the discrepancies. Normally, the insurer is under no obligation to inquire into the truthfulness of the representations made in the application unless the insurer is in possession of information that “distinctly implied” that the representations were false. For its part, the insured is required to establish “distinctly implied” with “clear and convincing evidence." Here, the court determined that the insured had met that burden. Therefore, the insurer waived its right to rescind the policies and was required to provide coverage for the fire at the facility at a cost of just under $1 million.

Detailed discussion: Sunwest Metals Inc. operates a recycling collection center in Anaheim, Calif., where it collects and sorts various recyclable materials to be sold to third parties for recycling. The company’s accountant served as the primary contact with the Dunlap Insurance Agency to procure insurance policies.

Dunlap in turn worked with G.J. Sullivan, representing Star Insurance Co. Star offered a “Scrap Dealers Program” that provided policies for companies like Sunwest—as long as the insured did not derive more than 15 percent of its annual revenue from paper or plastic.

Dunlap e-mailed a questionnaire to Star for an insurance quote stating that Sunwest’s annual sales were 80 percent aluminum, 20 percent iron and steel and “small amounts” of nonmetals. The underwriter considering the application visited Sunwest’s website and noticed it referenced paper and plastic recycling and contained images of stacks of baled cardboard.

A supplemental questionnaire again mischaracterized the paper and plastics recycling operation as minimal and made other errors about payroll and revenues. Despite questions about the commodities at Sunwest, the application was approved for $5 million in coverage, subject to a loss control report.

That report—based on a 10-minute site visit—also referenced paper as one of the recycled commodities and included photographs of large bales of cardboard in the yard. An inspection by the California Workers Compensation Independent Review Board provided to the insurer noted that paper products constituted 35 percent of the commodities at Sunwest.

Even when the policy was up for renewal and the insurer again found discrepancies between the commodities listed in the renewal application and the reports, Star renewed the policy.

In April 2013, a fire occurred at Sunwest’s facility that was determined to be arson committed by an unknown person. The policyholder notified Star and requested coverage under the policy. In the course of its investigation, the insurer became aware of the nature of Sunwest’s commodities and rescinded the policy.

Sunwest sued. A federal court judge granted partial summary judgment to Star, finding it undisputed that misrepresentations were made about Sunwest’s business on the applications but that genuine issues of material fact remained as to whether Star waived its right to rescind through its failure to conduct a reasonable inquiry.

After a five-day bench trial, U.S. Magistrate Judge Douglas F. McCormick issued 50 pages of findings of fact and conclusions of law ordering Star to pay almost $1 million to Sunwest.

“Under California law, an insurer’s right to information about material facts may be waived by its neglect to make inquiries as to such material facts where they are ‘distinctly implied’ in other facts communicated to the insurer,” the court explained. “Thus, although an insurer generally has no duty to inquire as to the truth of representations of fact made by the insured or its agent in an application, a duty to inquire may arise if the insurer or its agent is made aware of facts which bring those representations under suspicion and would induce a prudent person to make an inquiry.”

The “clear and convincing evidence” at trial established that the insurer was “in possession of facts that distinctly implied that Sunwest’s applications contained material misrepresentations regarding the extent of its paper and plastic recycling operation,” the court said.

Sunwest’s website indicated that paper and plastic were recycled on-site, a fact noted by an underwriter but not followed up on, Judge McCormick said. When the insurer received revenue information for the paper recycling, it did not seek clarification as to whether the numbers were annual, quarterly, monthly, or daily to put the amount in context.

The loss-control report should also have raised red flags for the insurer. “It is difficult to reconcile [the] loss-control report with Sunwest’s applications,” the court wrote. “Had anyone at Star Insurance compared the information in the loss-control report to the misrepresentations contained in the application, it is likely that Star Insurance would have discovered that Sunwest was not an appropriate risk for the Scrap Dealers Program.”

Particularly given the questions regarding Sunwest’s eligibility and the fact that neither Star Insurance nor its agents had an existing relationship with Dunlap or the applicant, the loss-control report’s “clear indication that paper was a significant part of Sunwest’s operations should have been investigated further.”

Photographs from a subsequent report—depicting large bales of cardboard in the yard—went unnoticed, and the report from the worker’s compensation inspection with numbers from Sunwest’s accountant that paper constituted 35 percent of the company’s business was ignored.

The insurer missed another opportunity when the policy was renewed, the court added.

“In sum, despite receiving several documents and communications that consistently showed that the amount of paper and plastics processing at Sunwest far exceeded that represented … and permitted under the [Scrap Program] Guidelines, Star Insurance and its agents did little to investigate or confirm the representations by the Dunlaps,” Judge McCormick wrote. “As Star Insurance’s own expert witness testified at his deposition, Star Insurance and its agents were ‘casual’ in the way they pursued the underwriting issues in this case.”

No one from the carrier ever spoke to Dunlap by phone—let alone in person—or requested a more thorough site visit than the 10 minutes spent for the loss-control report. “[T]he numerous red flags raised by the various reports and communications concerning Sunwest’s operations imposed upon Star Insurance a duty to investigate further,” the court said. “Having failed to do so, Star Insurance waived its right to rescind the Policies.”

The court ordered Star Insurance to pay Sunwest a total of $977,538.29.

Judge McCormick declined to award Sunwest damages for bad faith. A genuine dispute existed as to Sunwest’s entitlement to benefits under the policies, the court found, and Star’s decision to seek rescission was objectively reasonable, eliminating Sunwest’s claim of bad faith.

Even though the insurer did not correctly identify the reason it requested a breakdown of commodities processed by Sunwest during its investigation of the arson claim—Star said it needed them to calculate damages when it was really determining whether to rescind the policy—the court did “not find that these facts alone are sufficient to establish” bad faith by Star.

To read the findings of fact and conclusions of law in Star Insurance Co. v. Sunwest Metals, Inc., click here.

Compare jurisdictions: Arbitration

"I would like to thank the SCCA for this excellent service! The articles included in the newsfeeds are very useful and informative, and the user-friendly format of the newsfeeds means I can quickly glance over the précis in the emails to choose what to zoom in on."